Indian Economy, 5th edition (53 page)
Read Indian Economy, 5th edition Online
Authors: Ramesh Singh
The issue of volatility in capital flows has been of concern for several emerging markets (including India). The management of capital flows is tempered by two considerations:
(i)
The
first one
is the common challenge to most developing countries and EMEs, arises from the uncertainties in global capital flows and monetary policies pursued in advanced countries. Emerging markets face sudden
stops or reversals
(witnessed in December of 2011) for reasons not necessarily linked to developments in their own economies but to serious difficulties faced by financial institutions in advanced economies. Quantitative easing pursued by monetary authorities in advanced countries (while understandable in the context of liquidity needed to repair adverse private and public balance sheets) is a relatively new phenomenon that has altered the composition of capital flows and made their management by recipients more difficult.
(ii)
The second one specific to the India’s. Notwithstanding the stability of India’s balance of payments after an episode in 1991, India’s current account deficit has widened over the 2011-12. The dependence on private capital inflows to finance the same has widened. It is by now known that the burden of adjustment in the current IMS falls predominantly on non-reserve-issuing current account deficit countries (like India). On that count, the Indian economy has moved towards greater openness to capital flows, though following a cautious and calibrated approach of keeping both domestic and international factors and risks in view and through judicious use of multiple instruments promoting capital flows.
In the light of the shift in external vulnerability indicators and India’s currently high dependence on
imported oil,
there is need to reinforce management of the capital account (which has served India well) and also encourage more stable capital flows rather than short-term flows. Countries like India may well need to rely on a matrix of choices comprising macroeconomic and macro prudential tools and other measures as policy instruments without being bound by a prescribed sequence. Under the circumstances, the fact that the ‘Coherent Conclusions on Management of Capital Flows’ (as endorsed by the G-20) are ‘non-binding’ needs to be taken note of.
Given below are a brief overview of the
Vickers Commission Report
of the UK on its attempts towards the issue of Financial Regulation:
The Independent Commission on Banking under Sir John Vickers submitted its report to the UK government in September 2011. The highlights of the report are:
1.
One of the main reasons for bank failure during the global crisis was that they had too little equity in relation to risk- there were few restrictions on leverage.
2.
The weights assigned in the ‘risk-weighted’ assets of the banks turned out unreliable and the erosion of equity led to concerns of solvency and contagion.
3.
Though risks in banking have to rest somewhere, they should not fall on the taxpayer.
4.
On ‘Structural Separation’ and ‘Ring Fencing’ – the main recommendation is that there should be a
structural separation
between retail banking and wholesale/investment banking.
5.
There should be a ring fence to isolate banking activities where continuous provision of service is vital to the economy and to bank customers.
6.
Domestic retail banking should be inside the ring fence.
7.
Services should not be provided from within the ring fence if they are not integral to the provision of payments services to customers in the European economic area.
8.
Banks with both retail and investment activities will need to keep these activities at arm’s length but they could share information, infrastructure, etc.
9.
Structural separation would help sustain the UK’s position as a pre-eminent international financial centre, while UK banking is made more resilient.
10.
Loss absorbency: the report is in broad agreement with the direction of
Basel III
but notes that it does not go far enough since the leverage cap is too lax for systemically mportant banks and has recommended that retail banks should have equity capital of at least 10 per cent of risk-weighted assets (CRAR).
11.
The Commission has also recommended the introduction of a redirection service for personal and Small and Medium Enterprises (SME) current accounts which, among other things, would transfers accounts within seven working days.
The report has been a matter of great attention around the world, especially, among the EMEs. It is believed that the implementation of the
Vickers Commission Report
by the UK will see a wave of adjustments being followed by the other economies of the world. Thus, there are chances that via this the ‘good’ and the ‘bad’ of the financial regulation will automatically diffuse into the global economy, which may make or break the already fragile world economy!
An issue related to trends in
global liquidity
is dealing with the build-up of international reserves by some countries. It has been argued that the accumulation of reserves has
negative externalities
and also entails avoidable costs to the holding countries. The issue is when the holding of reserves can be deemed excessive or rather
what the optimal level could be,
if any, and whether some kind of ‘reserve metrics’ could be adopted. While the optimal size and the utility of using reserves to intervene in currency markets may be debatable, the experience, especially in the case of economies like India, has been that reserves have helped graduate to a more open economy and smoothen investment and consumption during periods of external uncertainties caused by extraneous factors. In this context, a distinction needs to be drawn between holding of reserves by countries running a current account deficit (such as India) and reserves accumulated by countries with persistent current account surpluses in addition to large sovereign wealth funds. A related set of issues on which deliberations have been going on in the G-20:
(i)
Concerns of strengthening of global financial safety nets;
(ii)
Cooperation between the IMF and Regional Financial Agreements to help countries deal with exogenous shocks (and access emergency assistance); and
(iii)
The adequacy of IMF’s resources to play systemic role for the benefit of its whole membership.
Financial Regulation
The G-7 countries along with a few more advanced economies with large financial sectors were the most important participants in a grouping that established the
Basel
Committee
on Banking Supervision in 1974, whose primary function was to act as a forum for coordination of supervision of the financial sector, particularly large banks, in these economies. In the wake of the major 2007-09 global financial crisis, the most severe since the 1930s, the effectiveness of financial regulation was called into question. Since then, quite significant reforms of financial regulation have taken place both within countries and internationally in terms of international regulatory standards and organisations.
Meanwhile, some of the advanced economies have started the process of
Financial Regulation Reforms
. In general, regulating financial markets and intermediaries and striking a balance between the need for maintaining financial stability and good market conduct without stifling innovation have always been a challenge. The global crisis brought home the inherent difficulty in doing that especially where financial institutions have had cross-border operations and exposures. This was because, with financial globalisation, many banks and other financial market participants had cross-border operations but were mostly subject to national regulations.
The weaknesses in financial regulation (apart from global imbalances) were perceived as a major cause of the global crisis. The Cannes Summit Communiqué 2011 (of the G-20) had reiterated the commitment that financial markets, products, and participants be regulated or subject to oversight appropriate to their circumstances in an internationally consistent and non-discriminatory way. The
declaration
spells out the initiatives taken that include the regulation of banks, over-the-counter (OTC) derivatives, compensation practices, and credit-rating agencies. The Cannes Action Plan commits to taking these initiatives further based on the work done by the Bank of International Settlements (BIS, Basel) and the Financial Stability Board (FSB)
27
on new standards for financial regulation.
The commitment to implementing the
Basel III
standards for banks is of particular significance to the global economy. The implementation of Basel III capital and liquidity standards starts in 2013 with full implementation envisaged by 2019. To make sure that no financial firm is ‘too big to fail’ and taxpayers do not bear the costs of resolution, the FSB framework comprising new international standards for resolution, supervision, cross-border cooperation, recovery, and resolution planning from 2016 was endorsed. The FSB has also published an initial list of
Globally Systemically Important Financial Institutions (G-SIFI)
and a five-pronged work plan to develop guidelines on shadow banking. In order to prevent excessive risk taking and discourage excessive pay and bonuses, the FSB has developed principles and standards on compensation.
As the members of the Basel Committee on Banking Supervision (BCBS) and FSB,
India
is actively participating in post crisis reforms of the international regulatory and supervisory framework. The Indian financial sector is well regulated and India remains committed to adopting international standards and best practices
calibrated to its conditions.
As such, banks in India are well capitalised and it is expected that the
Basel III
norms are unlikely to put undue pressure on the banking system on aggregate. India had even earlier implemented some countercyclical policies like provisioning norms and differential risk weights (for example for the real estate sector, capital markets, and personal loans) to control build-up of risks even before these were internationally proposed.
But, there are some caveats on the implementation of the emerging regulatory standards across countries. Given that the financial sector in many countries has its specificities, and there is likely to be resistance to change from several market participants, it is yet to be seen whether all these reforms will get carried out in all the countries and not diluted. While all G-20 countries have committed to implement Basel III, major jurisdictions have separately come out with their own regulatory standards: the
Dodd Frank Act
in the United States and the
Vickers Commission
recommendations in the United Kingdom with the EU too having its own rules. A concern that arises is that if same standards are not implemented in all jurisdictions simultaneously, there could be scope for regulatory arbitrage that could result in financial activity migrating to less-regulated jurisdictions, as well as into shadow banking. In the short run, there are also concerns that tightening of regulatory standards, even while recovery in advanced economies from the past and continuing crisis is not over, may make banks risk averse and adversely impact financial intermediation and lending to the
real sector
(i.e. the
real estate
sector).
Development Issues
The
G-20 Development Agenda
comprised a Multi-Year Action Plan based on
nine pillars
announced at the Seoul Summit, of which the French Presidency focused on
infrastructure
and
food security
for the Cannes Summit. The other pillars are
human resource development; trade; private investment and job creation; financial inclusion; growth with resilience; knowledge sharing;
and
domestic resource mobilisation.
Many of these issues have been in the subject domain of a number of developmental agencies.
While India has assigned high priority to issues relating to development appropriate to country-specific conditions, an issue deserving priority is of recycling global savings for infrastructure investment. Enhancing infrastructure investment in emerging economies and developing countries would have positive implications for rebalancing global demand as also for reviving and sustaining growth. At the same time, high savings would find productive use.
Role of Finance in Development
While on one side, global forums like the G-20 and international regulatory bodies continued to deliberate on issues relating to financial regulation, the year 2011 was also marked by rising concern across the world that ‘finance’ had somehow got de-linked from serving the interests of the real economy and that various regulatory and compensation practices are out of sync with the needs of the rest of the economy.
The issue of compensation in the financial sector has been a
major area of debate
not just in the G-20 but also in the media in general. Similarly, the issue of financialisation of commodities and speculation leading to volatility in commodity prices and the idea of implementing a tax on financial transactions have been contentious issues on which no clear consensus has emerged. Of late, an area of concern even among serious academic researchers has been whether the financial sector has become just too big in some advanced economies and whether its value addition is really genuine and correctly measured.
Whether these views and perceptions are correct or misplaced, regardless of this fact, these debates and the ongoing work need to be taken note of in policy. Fortunately, the
Indian
financial sector and its banks have thus far been well regulated and to ensure that it serves the real sector has been an abiding policy concern. Nevertheless, given the criticality of the role of finance in development, the Indian regulatory system would also need to maintain and strengthen its vigil to ensure that growth in the financial sector and the intermediation process go towards furthering economic development and financial inclusion.